8783 BIS Sustainable Growth WEB

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Economic Annex

A STRATEGY FORSUSTAINABLE GROWTH

JULY 2010


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We will work closely with the Devolved Administrations in Northern Ireland,

Scotland and Wales, recognising their particular and varying responsibilities.

While some of the policies in this paper are specific to England, the challengesare common across the four countries of the United Kingdom. Each will need

to consider the most appropriate arrangements in those areas for which they

have devolved responsibility, to address the issues in ways that meet their

own circumstances and needs.


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Contents

Contents

Introduction 2

1. Recent UK economic performance 3

2. Achieving sustainable growth 6

The global context for growth 6

What drives growth? 7

More balanced growth 8

3. The Way Forward 11

A. Promoting the efficient operation of markets to support growth 11

Domestic competition frameworks 11

Need for banking reforms 12

International frameworks and openness to trade 13

Better regulation 15B. Encouraging investment in our productive capacity to drive growth 17

Access to finance 17

Infrastructure 18

Higher education and skills 20

Science, research and innovation 23

C. Encouraging entrepreneurialism 25


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A Strategy for Sustainable Growth Economic Annex

Introduction

Laying the right foundations for growth is paramount as the economyrecovers. Growth is needed to raise living standards, deliver high quality

public services and meet the challenges of an ageing population and climate

change.

The Emergency Budget set out a medium term plan to put public finances on

a sustainable footing, build business confidence and provide a springboard

for a private sector-led recovery. This is the first step in transforming

our economy. Microeconomic policies will support the macroeconomic

framework by focusing on the longer term and the supply side of our

economy.

The challenge is to rethink growth policies under tight public finances. This

involves having a clear understanding of aspects of our recent economic

performance that were unsustainable, how to provide businesses with the

right conditions to drive growth, and where investments get the highest

returns. We have to realise the twin aims of securing deficit reduction and

promoting sustainable growth. Our growth prospects will be undermined if

we do not have a credible deficit reduction plan, but equally, deficit reduction

over the medium term requires significant and sustained growth.


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Recent UK economic performance

1. Recent UK economic performance

The headline performance of the UK economy in recent years may in someways appear respectable. The UK economy grew, at an average rate of

growth of 2.0 per cent per annum between 1990 and 2009. The UK also

made significant progress in closing the productivity gap with Germany,

and narrowing it with France, although the gap with the US has remained

stubbornly large1. The UK also had a relatively low unemployment rate in

the years before the recession, at an average of 5.2 per cent over 2000-2007.

However, this growth model has proved unsustainable.

As the Emergency Budget set out, economic growth in the UK has been

driven by the accumulation of unsustainable private sector debt and risingpublic sector debt:

The household saving ratio had, by 2008, fallen to the lowest level since the

1950s and household debt had risen to 100 per cent of GDP2, as households

borrowed heavily to purchase increasingly expensive property, which grew at

an average of around 9 per cent a year3. Reflecting this, private consumption

typically accounted for almost two-thirds of annual GDP growth over the

period 2000-07.

Business investmenthas been particularly low. Business investment andinvestment in dwellings, each contributed on average, just a quarter of a

percentage point to average annual GDP growth of 2 per cent over the same

period. Since 2003 the share of business investment has been predominantly at

the lower end of the historical 10-12 per cent of GDP range, dropping below 10

per cent of the economy in three out of the last six years. During the recession,

business investment has been exceptionally hard-hit, falling in six successive

quarters by a total of 25.7 per cent since the autumn 2008.

According to the OECD, by 2007, the UK had the largest structural budget

deficit in the G7. Government spending4 has been the second mostsignificant driver of annual GDP over the period 2000-2007, contributing, on

average, three quarters of a percentage point to average annual GDP growth

over the period. During the recent recession, the budget deficit increased

sharply, with a related increase in Government indebtedness. Public sector

1 Between 1998 and 2008, the UK closed the productivity gap (measured as output per

worker) with Germany, the gap with France was narrowed (from 14 per cent to 9 per cent)

while the gap with the US widened slightly (to 33 per cent from 30 per cent), according to

ONS International Comparisons of Productivity

2 HMT (2010), Budget, June

3 Nationwide House Price Index Survey (2010), June

4 Government consumption and investment combined


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net borrowing is forecast to peak at 11 per cent of GDP this year. The IMF

forecast that the UK will have the highest borrowing rate in the G20 this year.

Net trade hasdragged down GDP growth over 2000-2007, subtracting

on average a quarter of a percentage point from average annual GDPgrowth over this period. Indeed, since 1996 net trade has made a positive

contribution to the overall economy in volume terms in three years (2006,

2008 and 2009).

Sectoral growth has been unbalanced towards financial services. In recent

years, financial intermediation in the UK grew faster than in any other G7

country, and much faster than growth in the UK economy as a whole5. Even

when one adjusts for the faster growth of the whole UK economy over

the period, it can be seen in Chart 1 below that amongst major industrial

economies only the US saw financial services account for such a largeproportion of overall growth in the economy between 1997 and 2007.

UK bank balance sheets nearly tripled between 2002 and 20076.

Chart 1: Financial services contribution to GVA growth (1997-2007)

0

3

6

9

12

15

US GermanyJapanFranceCanadaItalyUK

PercentageoftotalGVAgrowth

Source: BIS calculations from OECD STAN database

Although growth in large parts of the financial services sector have played

an important role in creating jobs and raising incomes in the UK, it has

5 Between 1997 and 2007 the UK banking sector (retail and wholesale) expanded by 139

per cent; the UK financial intermediation sector (insurance, broking, fund management,

banking) increased by 80 per cent (it increased by 60 per cent in the US and remained

stable in Germany) (OECD STAN database for structural analysis). Financial corporations

total debt doubled between 2000 and 2008, rising from 126 per cent to 240 per cent of

GDP. By 2008, UK financial corporations indebtedness was the highest in the G7 (OECD

National Accounts database)

6 Speech by Mervyn King, Governor of the Bank of England, at the Lord Mayors Banquet

for Bankers and Merchants of the City of London at the Mansion House, 16 June 2010


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Recent UK economic performance

been clear since the onset of the downturn that this growth has not in

fact brought about a permanent increase in overall living standards in

the UK. The Office for Budget Responsibility (OBR)7 highlighted that: the

adjustment of the financial sector may reduce its direct contribution to whole

economy productivity. For example, a reduction in the financial sectorsshare of output from its pre-crisis level of around 8 per cent to 7 per cent

could reduce the whole economy level of productivity of around per

cent. NIESR8 also suggested that the adjustment of the financial sector may

reduce the sustainable level of output by around 1 to 2 per cent based on the

assumption that the financial sector share of output reverts to its share in

2000 of just over 5 per cent.

Growth has been unevenly spread between regions. For the last forty years,

London and its surrounding regions have grown faster than the rest of

England. Since 1989, the gap averaged over percentage point9. The recentrecession has lead to further imbalances. As a result, workers and firms earn

46 per cent10 more in London and the surrounding regions than the rest of

England, with London workers earning more than twice the level seen in

the North East. Moreover, output in some parts of the country has been too

dependent upon public sector activity.

Employment in the public sector rose much faster than in the private sector.

General Government employment rose by 690,000 (14 per cent) from 4.8

million in 1999 Q1 to 5.5 million in 2010 Q2. Private sector employment stood

at 22.8 million in 2009, up by 911,000 (4 per cent) from 21.9 million in 1999.

The economic downturn has impacted on the economy, leading to a decline

in UK productivity. Labour productivity11 has fallen on a year on year basis

in six successive quarters, between 2008 Q3 and 2009 Q4. The latest data

for 2010 Q1 show that productivity began to grow again, rising by 1.3 per

cent on 2009 Q1, as a result of both a small increase in output and a fall in

labour input. Since the beginning of the recession, there has been a rapid

and sizeable increase in ILO unemployment rate from 5.2 per cent in 2008 Q1

to 8 per cent in 2010 Q1, although less than in past recessions. Greater wage

moderation and shorter working hours, as well as the efficiency of UK labour

markets, have all contributed to this. However, unemployment rates for the

young and the low skilled have particularly increased.

7 OBR (2010) Pre-Budget Forecast, June, p.76

8 NIESR (2009), Growth prospects and financial services, Economic Review Vol.207, January

9 ONS Regional Accounts

10 BIS calculations from ONS Regional Accounts

These differences in headline earnings do not reflect possible changes in regional prices

which would impact on real incomes

11 Measured as output per worker


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2. Achieving sustainable growth

We have to lay the foundations for a new type of growth in the UK, onethat is sustainable. This means building a more competitive and productive

economy, which crucially requires markets to function well.

The global context for growth

While growth in advanced economies, particularly in Europe, remained

fragile in the first half of 2010, and well below pre-crisis rates, the broader

world economy has continued to strengthen. World trade is forecast by the

OBR12 to rise by 6 per cent this year followed by 6 per cent in 2011, and

around 7 per cent in 2012-14. Global growth is forecast to rise by 4 percent this year. Emerging Asia is leading the recovery, with many countries

growing at above trend rates. Global growth is forecast to rise by 4.2 per cent

next year, then by 4.5 per cent in 2012-13 and 4.6 per cent in 2014-15. In line

with the growing world economy, UK export markets are forecast by the OBR

to grow by 4 per cent in 2010, 4 per cent in 2011 and by close to 6 per

cent thereafter. Whereas Europe and the US will continue to be important

trading partners, improving the UKs openness to global trade, particularly

in fast-developing economies, is key for our growth prospects. World

growth will continue into the longer-term as incomes rise in both developed

and developing economies and consumers and businesses look to take

advantages of developments in new technologies, and respond to the need

for a lower carbon economy and ageing populations in advanced economies.

Growth therefore will be also based upon UK companies being successful in

global markets.

Restoring the competitiveness of the UK as a location for economic activity

is important. In the near term, the lower pound provides a boost to the UKs

competitiveness. UK exporters are benefiting from the 25 per cent fall in the

trade-weighted value of sterling since July 2007. While there are indications

that many firms have used this as a breathing space to rebuild margins and

balance sheets, as the recovery picks up, a lower level of sterling provides a

real opportunity for firms to raise their export presence.

In the longer term, in a global economy where capital, goods and workers

are increasingly mobile, other factors such as taxation rates directly affect

cost or price differentials and therefore UK firms profitability. The Emergency

Budget announced a package of reforms to the corporate tax system,

ensuring the UK continues to have the lowest corporation tax rate in the G7

and one of the lowest in the G20 when fully implemented. Key measures

include reducing corporation tax from 28 to 24 per cent over the course of

12 Pre-Budget Report, June 2010,OBR, p.14


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Achieving sustainable growth

four years from April 2011; reducing the small firms rate of corporation tax

to 20 percent from April 2011; and lowering the cost of national insurance

contributions to make it cheaper for companies to employ people. Lower

business taxation, combined with the depreciation of sterling, will allow UK

businesses to enhance their export competitiveness.

What drives growth?

A more competitive tax regime has an important role to play in creating the

conditions for growth, but there is much more that government can do. Fiscal

consolidation will underpin private confidence and reduce competition for

funds for private sector investment, supporting job creation and growth over

the medium term.

Over the longer term, growth will be dependent upon both the efficiency

of markets and the effectiveness of investment made in our productive

capacity, underpinned by strong entrepreneurialism.

Analysis from the internationally recognised Groningen Growth and

Development Centre (chart 2) suggests that UK growth benefited prior to the

recession from increased labour input and increasing skill levels, as well as

strong investment in Information and Communication Technologies (ICT). But

broader investment has been less strong by international comparisons, and

the efficiency within which these inputs have been combined (so-called Total

Factor Productivity) has been weak, suggesting that either the investments

that business and government have chosen have not been optimal, or that

we have not made the best use of those investments.

Chart 2: Composition of GVA growth (1997-2007)

0

5

10

15

20

25

30

35Total Factor Productivity

Non ICT capital

ICT capital

Skills

Hours worked

GermanyFranceUKUS

Contributiontogrowth(percen

tagepoints)

Source: Groningen Centre for Growth and Development


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International organisations such as the OECD13 identify a role for government

in both strengthening economic fundamentals and encouraging investment

in growth capacities.

Such investment is particularly important in enabling UK firms and workersto compete successfully in global markets. In recent years low-wage

economies have improved their skills levels and business sophistication,

enabling them to compete in more markets. The UK needs to respond to this

challenge by ensuring our skills and innovation capabilities are of world-class

levels to enable us to develop and compete in new markets.

More balanced growth

Over the next couple of years the UK will undergo significant structural

adjustments. The Office for Budget Responsibility14 expects the economy to

rebalance away from consumption towards investment and net exports,

with most of this re-balancing expected to take place from 2011 onwards. The

measures taken in the Emergency Budget on public spending and tax will play

an important role in building the conditions to support more balanced growth.

But there is more that government can and must do. We need to set out

a strategy for a new growth model: one that delivers sustainable growth

in an economy that is no longer over reliant on big government, debt or

financial services and one which rebalances the economy so that firms

and individuals have the opportunity to innovate and grow. Sustainable

growth involves balancing economic development, social development and

environmental protection. There is no wide agreement on what the optimal

balance between regions and sectors should be. The long run economic

trends that have led to changes in the regional and sectoral composition of

our economic activity are in part the result of global economic forces which

government cannot and should not look to reverse. However, government

has a key role to play in removing specific barriers to growth for all regions

and sectors of the economy, building on the efficiency and flexibility of the

UK labour markets.

All regions must be enabled to realise their full potential. It would be

unrealistic to expect regions to all have the same level of income per head,

and both structural and wider geographical and sociological forces will mean

that different regions enjoy differing periods of growth over time. But the

extent and persistence of present imbalances mean we are not maximising

our overall potential. Furthermore, output in regions outside of London has

been too dependent upon public sector activity and will have to be replaced

by strong, private sector growth.

13 OECD (2001) The New Economy: Beyond the Hype, Growth Project Final report

14 OBR (2010) Pre-Budget forecast, June


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Achieving sustainable growth

Growth must be diversified across a wide range of sectors to underpin a

more resilient economy. The UK has seen a long-term shift towards services,

with manufacturing as a share of overall GDP in the UK declining from 32

per cent in 1970 to its current level of around 12 per cent 15. This broad shift

in GVA and employment from manufacturing to services is a long-term trendand common to all G7 economies (chart 3). It results from both globalisation

and difference in scope for productivity growth between sectors, feeding

through to final prices, which have fallen for most manufactured goods

relative to services.

Chart 3: Manufacturing as a share of GDP (1990-2008)

Percentage

ofGDP

0

5

10

15

20

25

30

Canada

United Kingdom

United States

France

Italy Germany

Japan

1990

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

Source: UNCTAD Handbook of Statistics (2009)

Whilst on some measures of overall sectoral concentration, the UK does

not look out of line with other major economies, the rapid shift we have

seen towards financial services, means that we are increasingly at risk ofbecoming less diversified, and less resilient to the economic shocks this can

bring. As McKinsey16 and others have pointed out, achieving a broad based

shift in the economy towards manufacturing would be challenging against

the long-term global forces described.

Chart 4 shows the UKs revealed comparative advantage, with a positive

figure showing that UK exports are particularly focused on a given sector.

The overall picture is of specialisation in areas such as aerospace and

chemicals, as well as a range of business services where competition is

15 ONS (2009) Blue Book

16 McKinsey Global Institute (2010) How to Compete and Grow: A sector guide to Policy,

March


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primarily on the basis of high skills and technology rather than low wages.

There is also evidence of strong performance in a range of niche markets, for

example, machinery and technical textiles17. We need to build on and expand

our strengths in these areas, as well as look for new areas in which we can

build internationally competitive firms.

Chart 4: Revealed comparative advantage in selective sectors

-0.4 -0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Textiles (1.5%)

Plastics/Rubbers (2.1%)

Metals/Metal products (4.6%)

Machinery/Electrical products (14.0%)

Wood/Wood products (1.5%)

Miscellaneous manufacturing (3.1%)

Transport equipment (6.2%)

Mineral products (8.3%)

Travel (4.9%)

Foodstuffs (2.3%)

Chemicals/Related industries (5.7%)

Transport (5.3%)

Stone/Glass/Ceramics (3.3%)

Computer and info. services (1.8%)

Aerospace (1.9%)

Pharmaceuticals (4.1%)

Other business services (11.2%)

Communications (1.3%)

Insurance (1.8%)

Financial services (9.2%)

UK RCA

Source: IMF and UN COMTRADE

Lastly, environmental quality and renewable resources must be maintained.

We need to make sure our economy responds to the need to draw on the

natural environment more sustainably, with carbon emissions falling to meet

internationally agreed targets. But the low carbon industry also provides a

particular opportunity for balanced economic growth, both geographically

and sectorally; extending high-value, high-tech manufacturing in different

areas of the country whether it be the Midlands and the North East for low

emission vehicles, or the North West for the manufacture of components for

the growing nuclear energy market. Support for innovation and infrastructure

in these areas can build on geographical and industrial strengths.

17 Intra-industry trade, including the process whereby components are imported, placed in

a product and then re-exported, means that we should be cautious in interpreting export

data.


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The Way Forward

3. The Way Forward

Our strategy is therefore to promote the efficient operation of markets andencourage investment in our productive capacity, underpinned by strong

entrepreneurialism.

A. Promoting the efficient operation of markets to

support growth

Markets drive investment and growth, through encouraging productivity

improvements, through both efficiency improvements within firms and the

entry of more competitive firms. But markets can fail to deliver desirable

outcomes for a range of factors, relating to externalities and tendencies for

markets to move toward non-competitive structures. Government has a

key role in setting how markets operate to ensure that the financial sector

supports investment in the economy, competition is fair, markets are open

to trade, and regulatory burdens on businesses are reduced.

Domestic competition frameworks

The benefits of competition on our growth potential are wide ranging.

Competitive markets provide strong incentives for firms to increase their

efficiency, driving down costs, and encouraging innovation in products

and processes. Market discipline also ensures that the more efficient firms

prosper, and leads to the economy becoming more productive overall.

The potential gains from the increased allocative efficiency in the economy

which may arise from limiting the abuse of market power have been shown to

be substantial, and estimated to be in the order of 0.51 per cent of GDP across

the economy as a whole. The dynamic benefits of competition substantially

exceed the more easily estimated static benefits. There is, for example, strong

evidence of competition driving firm-level productivity, through its effects onmanagerial incentives18, through inter-firm effects such as natural selection

of firm entry and exit, and through incentives to innovate19.

Consumer confidence in markets is also essential to their proper functioning.

Consumers need to be confident that goods on offer are correctly described

and their rights can be enforced; lack of confidence in this area can reduce

demand. Hence the consumer framework has an important place in the

creation of competitive markets. Similarly, the pressure to attract and retain

18 Bloom and Van Reenen (2007) Measuring and Explaining Management Practices Across

Firms and Countries

19 Ahn (2002) Competition, innovation and productivity growth: A review of theory and

evidence, OECD Economics Department Working Papers, No. 317


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customers provides a strong incentive for businesses to act responsibly

and improve their products and services. Confident consumers, who are

adept at exercising choice, can therefore exert significant pressure on

business practices without the need for burdensome regulation. There is

growing evidence to show that empowered consumers act as a spur to drivecompetition and as a driver for firm-level innovation20.

The UK domestic competition regime is ranked among the best in the

world. The Global Competition Review gives the Competition Commission

its highest rating, at five stars, putting it on par with the US Department of

Justice and the Federal Trade Commission. The Office of Fair Trading receives

a 4.5 star rating, equal to that accorded to the EC, Australia, France, Germany

and South Korea21.

Going forward, the challenge will be to get the balance right between athorough and rigorous competition regime on the one hand, and simple

regulation and fast process on the other hand; and to ensure that effective

competition underpins and supports a range of future policy proposals, such

as on banking reform.

Need for banking reforms

If the economy is to be encouraged to evolve in a sustainable way, it is critical

that the ability of the financial sector to support investment is not limited by

past regulatory failures. Financial institutions, especially banks play a keyrole in financial intermediation, pooling funds from savers, and lending on

to businesses and consumers. But the financial crisis and resulting recession

showed the impact that systemic problems in the banking sector can have on

the wider economy, reducing the availability of finance for business.

Steps have been taken to address these problems, to improve financial

stability and strengthen the role of the financial sector in financial

intermediation. Changes will be made to banking regulation, both in terms

of institutional reform to UK regulatory system, and the implementation of

the global agenda on financial sector reform in areas such as strengtheningcapital and liquidity requirements. The G20 Toronto summit declaration

makes clear that these new standards will be introduced over a timeframe

that is consistent with sustained recovery.

The Independent Commission on Banking has also been established to

formulate policy recommendations to reduce systemic risk in the banking

sector, mitigate moral hazard, reduce the likelihood and impact of firm failure,

and promote competition in both retail and investment banking.

20 Waterson, M. (2004) Research to analyse the links between consumer empowerment,

competition and productivity and to scope further work which could be undertaken to

quantify these effects, University of Warwick

21 Global Competition Review (2010), Enforcement Ratings survey


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The Way Forward

International frameworks and openness to trade

Trade can contribute to growth. There is a close correlation between trade

and growth, although trade is more volatile22.The benefits of exporting are

well established and cover access to bigger markets, increased revenue,increased probability of firm survival and more innovation, research, and

development. Imports also provide hugely important benefits that include

cheaper inputs, more choice, and access to the benefits of innovation from

around the world.

UK firms that import services have better performance characteristics

in terms of productivity and employment than firms which do not trade

services. Analysis23 suggests that UK firms which import services account

for 2.8 per cent of all firms but 7.9 per cent of employment and 11.2 per cent

of output. Firms which both export and import services perform even better

accounting for 4.4 per cent of firms but 11.3 per cent of employment and

16 per cent of output.

The UK is the worlds 6th largest exporter and importer of goods and

services. It is the 2nd largest exporter and 3rd largest importer of services,

with manufacturing still accounting for the largest share of UK imports and

exports (see chart 5).

Chart 5: Imports and exports, value by sector 2009 (m)

0

50,000

100,000

150,000

200,000

250,000

Exports

Imports

ServicesManufacturingBasic materials,

fuel and miscellaneous

Food, beverages

and tobacco

Source: ONS

22 Trade declined much more sharply than GDP in the crisis (-12 per cent compared to -0.6

per cent); it is expected to bounce back more rapidly this year (growing by 9.5 per cent

compared to 4.2 per cent) according to WTO and IMF forecasts

23 Breinlich and Cricuolo (2009) International Trade in Services: A Portrait of Importers and

Exporters, CEPR Discussion Paper 7837


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Net trade (export less imports) is expected by the OBR to boost GDP growth

by around of a percentage point in 2011 and 2012 and to continue to

contribute positively to growth.

Trade and investment are linked. Inward investment also generatesknowledge and productivity spillover benefits. The UK is one of the most

attractive destinations for inward investment in Europe. According to

UNCTAD24, the UK has historically attracted more FDI stock than its main

competitors (chart 6).

Chart 6: Stock of inward Foreign Direct Investment

0

200

400

600

800

1000

1200

1400

United Kingdom

Netherlands

Germany

France

20082007200620052004200320022001200019991998199719961995

US$bn

Source: UNCTAD

However competition with the UK has intensified. According to Ernst and

Young25, annual project numbers have fallen substantially in Europe in 2009.

The international framework of regulation which enables trade is incomplete.

Working closely with the EU to make progress on multilateral and bilateraltrade agreements and implementing existing agreements to reap their full

benefits is the most effective way to lead to an improvement of the UK

export performance, for instance through helping UK businesses tackling

barriers to entry.

The UKs export dynamism is for a large part dependent on the situation

in the EU, which accounts for around 50 per cent of UK trade in goods and

services. UK export growth will be made much more difficult if the rest of

the EU stagnates. To protect and ensure Europes economic recovery, Single

24 UNCTAD (2009) World Investment Report

25 Ernst and Young (2009) European Investment Monitor


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The Way Forward

Market integration and simplification of the administrative burden have the

potential to drive a substantial increase in European countries growth rates

by several percentage points26.

Better regulation

Appropriate use of regulation can help improve a countrys economic

performance. A key aim of regulation is to redress market failures and ensure

a more efficient allocation of resources. Other motives for regulation can

involve the pursuit of social goals to maximise the societys overall welfare.

Recent estimates in the UK and US suggest that the benefits of regulation

outweigh costs27. In the UK, government regulation is expected to deliver at

least 1.85 in yearly benefits to society for every 1 of cost. A number of recent

international surveys, such as The World Banks Doing Business series, have

established links between macroeconomic variables (e.g. GDP) and regulatory

quality. For instance, a recent internal study estimated the overall benefits

in the UK of cartel regulation to be 250 million per year, a net benefit of

230 million28; measurement standards regulation have been estimated to

contribute about 0.8 per cent of GDP29 to the UKs economic growth.

However, as economies become more complex, and more regulations are

introduced, the cumulative burden can restrict growth by raising the costs

of operating a business in placing both financial and time demands on it,

and by creating overly complex incentive structures. The implementation

of the regulation is as important as its legal design. According to business

surveys, the areas that impose the highest administrative costs are health

and safety law, employment law, taxation law, sector specific legislation and

environmental law30.

The indirect impacts of regulation are also important as these can add

additional burdens and affect incentives, having a direct bearing on the

UKs competitiveness. For example, effective use of land is essential for

business growth. Land use regulation is necessary to overcome market

26 Ilzkovitz, F., Dierx A., Kovacs V., and Sousa N (2007) Steps towards a deeper economic

integration: the Internal Market in the 21st century. A contribution to the Single Market

Review, Ecofin Economic Paper No 271

27 HMG (2009) The Total Benefit/Cost Ratio of New Regulations 2008-2009; US Office for

Management and Budget, (2008) Report to Congress on the Benefits and Costs of Federal

regulations

28 DTI (2006) The impact of regulation: a pilot study of the incremental costs and benefits of

consumer and competition regulations

29 PA Consulting Group (1999) Review of the Rationale for and Economic Benefit of UK

National Measurement System

30 BIS (2008) The Annual Small Business Survey 2007/08


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failures, which would otherwise prevent the efficient allocation of land to

different uses. However, by specifying which land can be developed and how,

regulations affect the price of land. Recent research suggests that planning

regulations increase the cost of office space in London much more than

other European cities31. Moreover, businesses are significantly less likelyto feel informed about Planning Law than other areas of regulation32. And,

whilst planning permission is the major risk for developers, the cost, time

and unpredictability of the process required to obtain non-planning consents

exacerbates the challenges a developer faces in dealing with planning

issues.33

Overall, the UK ranks relatively well in some international surveys of

regulatory burdens but less so in others (chart 7). There are signs that,

while UK regulatory barriers may not be increasing, other countries may be

catching up with and, in some cases, overtaking the UKs efforts at reducingregulatory burdens.

Chart 7: UK International Ranking of Government and regulatory burdens

Rank WEF Global

Competitiveness

2009/10

World Bank 2010 OECD Barriers to

Entrepreneurship

indicator 2008

1 Switzerland Singapore United Kingdom

2 United States New Zealand Netherlands

3 Singapore Hong Kong Sweden

4 Sweden United States Italy

5 Denmark United Kingdom Korea

13 United Kingdom

Sources: WEF; World Bank; OECD

It is important that the UK economy is underpinned by the right regulatory

framework that supports business creation and growth, and avoids imposingunnecessary burdens which would undermine UK competitiveness. New

regulations must address market failures or be clear about the objectives they

intend to deliver. It is equally imperative to look at the stock of regulation,

to ensure regulations remain fit for purpose given changing market

circumstances, and responsive to business needs.

31 Cheshire and Hilber (2007) Office space supply restrictions in Britain: The political

economy of market revenge

32 NAO (2010) Business Perceptions Survey

33 BIS (2010) Penfold Review of non-Planning Consents, Interim Report, March


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The Way Forward

B. Encouraging investment in our productive

capacity to drive growth

Evidence shows the crucial importance of investment in capital (buildings,equipment and infrastructure), skills, science and innovation in driving

growth. Public investment is complementary to private investment.

Government can encourage investment by minimising uncertainties and

correcting sources of market failures, both in capital markets and in areas

that would otherwise be under-invested because the benefits to the economy

are over and above those borne by workers or businesses.

Access to finance

Growth requires access to appropriate finance. Businesses have a numberof options to finance investment and growth, some will use cash generated

in the business while others will seek external finance. External finance can

include a combination of bank credit such as loans and overdrafts, non-bank

lending such as public or private bonds, or equity investment.

The financial crisis of 2008 led to an immediate reduction in the supply of

credit from the banking sector to business (Chart 8), causing significant

difficulty for firms utilising external finance. Since the crisis, many

borrowers have experienced higher spreads over the Bank of England base

rate. Businesses have improved their resilience by cutting costs, delayinginvestment and building up cash reserves, thus reducing the demand for

bank finance. Therefore bank lending activity is very weak across most

developed countries with the UK, US and Euro area all having witnessed

contractions in the net flow of bank credit over the last twelve months.

Chart 8: Lending to UK businesses

-15

-10

-5

0

5

10

15

20

25

30

35

All businesses

SMEs

Mar

2010Jan2010

Nov2

009

Sep2

009Jul2

009

May

2009

Mar

2009Jan2009

Nov2

008

Sep2

008Jul2

008

May

2008

Mar

2008Jan2008

Nov2

007

Sep2

007Jul2

007

3monthannualisedgrowth,percent

Source: Bank of England Trends in Lending (June 2010)


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Now, as the economy grows and business confidence returns, many

businesses will increase investment again and grow. The challenge is for the

supply of finance in general, and the banking sector in particular, to support

rather than constrain the recovery. This concern is particularly marked

with respect to small and medium sized businesses, given their historicreliance on bank lending. As banks seek to reduce their leverage and extend

the maturity of their funding34, combined with the potential impact of the

regulatory changes, there is a risk that the availability of bank finance will

again restrict the supply of finance to creditworthy firms.

Large businesses, as well as some mid-sized companies, have been able to

access the capital markets as an alternative to bank debt. There was record

issuance of debt and equity in 2009 enabling a more diversified finance

portfolio.

Alongside the changes to the finance environment experienced through

the recession there are some long-term structural market failures that may

prevent some companies from getting the finance that they require.

Imperfect information makes it difficult for both investors and businesses to

make optimal investment decisions. The high cost of obtaining information

on the viability of SMEs relative to the size of funding they are seeking leads

to potentially viable businesses not being able to raise finance. This is an

issue for bank lending and equity.

The Green Paper on Business Access to Finance, to be published before the

summer recess, will explore some of these issues in more detail.

Infrastructure

Good infrastructure networks support economic activity and growth and

conversely, economic growth increases the demand on infrastructure. The

UKs infrastructure networks enable people, goods, energy, information

and water to move efficiently. In this way, the capacity and quality ofinfrastructure directly affects labour and product markets and competition

within these. Infrastructure also facilitates innovation by lowering the cost

and increasing the speed of communications.

Recent empirical work by the OECD35 found that over the period 1970-2005

investment in UK roads, rail and electricity had a stronger positive effect on

the level of GDP per capita, and short term growth, than would have been

the case for other types of capital investment, demonstrating the strong

contribution that infrastructure has made on growth.

34 Bank of England (2010) Financial Stability Report, June

35 Egert, B., Kozluk, T. and Sutherland, D. (2009) Infrastructure Investment: Links to Growth

and the Role of Public Policies OECD Economics Department Working Papers, No. 686


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The Way Forward

Both private and public investments contribute to infrastructure. Government

has a major role in supporting infrastructure development; ensuring private

investment exists alongside fair prices where there are natural monopolies

e.g. in utility networks and rail; ensuring land is available through the

planning system; and as a provider where the market alone is unlikely todeliver optimal levels of infrastructure e.g. in roads.

The performance of our existing infrastructure varies by mode but the World

Economic Forums 2009/10 Global Competitiveness Index placed the UK only

33rd out of 133 economies, behind many other G8 countries (chart 9).

Chart 9: Global Competitiveness Index Infrastructure quality in G8countries

0

1

2

3

4

5

6

7

2009-2010

2007-2008

RussiaItalyUKJapanUSCanadaGermanyFrance

Source: World Economic Forum

Demand for UK infrastructure investment up to 2030 and beyond is forecast

to be significantly higher than historic levels. Approximately 150 billion was

invested in UK economic infrastructure between 2005-2010, predominantly

by the private sector. There are substantial challenges to meeting potentialfuture demand for infrastructure of around 40-50 billion per annum until

203036. Investment in infrastructure by both the private and public sector is

necessary to allow growth and to meet new demands such as population

growth, the needs of the energy sector and the development of low-carbon

technologies.

As with other forms of financing during the credit crunch, the cost of PFI

financing has increased. This is due to the combination of a lack of liquidity

in the bank market and an inability to access the capital markets for PFI

assets. This resulted in increased pricing and stricter terms and conditions

36 HMT (2010) Strategy for National Infrastructure


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from funders. Despite this, PFI projects provide value for money and continue

to cut across a wide range of asset classes.

However, the market remains uncertain about making long-term investment

commitments and new regulations which require banks to allocate morecapital to long-term lending could result in a further decline in capacity.

Alternative sources of investment from capital markets and institutional

investors would provide a wider funding base and would help to reduce

reliance on bank finance. However, at present the risk profile of PFI projects

with construction risk is unable to achieve the necessary rating to attract

these sources of finance.

Higher education and skills

Investment in higher education and skills is essential to provide individuals

with the competencies that will enable them to find employment in the

knowledge economy and to contribute to social mobility and fairness.

Greater levels of skills lead individuals to work more effectively, adapt to

changes better and carry out more complex tasks. Graduates in particular

complement innovation and facilitate the introduction of new ideas and

technologies. Higher levels of management capability are associated with

a higher ability of firms to make the most effective use of skills in their

overall business strategy. Evidence that attempts to estimate the benefits

of qualifications to individuals in terms of wage enhancements in the

labour markets37 shows that acquiring qualifications leads to considerable

and increasing returns on investment. It also indicates that for vocational

qualifications there are greater benefits when acquired through the

workplace38.

The demand for highly-skilled workers and an increasingly mobile workforce

also explains net inward migration to the UK over the last decade.

The majority of work permits issued to nonEEA nationals have been

37 McIntosh (2009) The Economic Value of Intermediate Education and Qualifications,

UKCES Evidence Report

38 Jenkins, Greenwood and Vignoles (2007) The returns to qualifications in England:

updating the evidence base on level 2 and level 3 vocational qualifications


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The Way Forward

predominantly in the most skilled occupations39. Research suggests that

immigration made a positive contribution to growth in the UK40.

Information failures, both amongst learners and firms, may lead to sub-

optimal levels of investment in training. Problems with access to financemay deter some individuals, particularly those from lower socio-economic

backgrounds, from being able to invest in training or education. The potential

for firms other than those making the investment to benefit from spillover

effects may also limit the amount of skills investment undertaken.

Since 2000 there has been an increase in UK educational attainment. Yet

persistent gaps remain in management quality41 and in some STEM subjects

such as engineering (see chart 10).

Chart 10: Percentage of tertiary graduates by field of education

0

5

10

15

20

25

30

35

40

OECD average

UK

Maths/

computing

Life

sciences

EngineeringHealth/

welfare

HumanitiesSocial

sciences

Source: OECD

39 Salt (2008) International migration and the United Kingdom: Report of the United

Kingdom SOPEMI Correspondent to the OECD, Migration Research Unit

40 Research undertaken by the National Institute for Economic and Social Research

estimated that immigration accounted for 17 per cent of economic growth in 2004 and

2005. HMT estimate that between the third quarter of 2001 and mid 2006 immigration

increased the working age population by 0.5 per cent per annum. This accounted for

between 15 and 20 per cent of output growth between 2001 and 2006, adding around 6bn

per annum to the UK economy. However, as noted by the House of Lords, the impact of

immigration on the overall size of the economy (GDP) is not a useful measure of living

standards and that the focus should be on GDP per head, or even GDP per head of the

resident population.

41 CEP/McKinsey & Company (2007) Management practice & productivity: Why they

matter?


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Overall, the UK remains a middle-ranking country in terms of qualifications

(see chart 12). In particular, the UK continues to have a long tail of

people with low skills. In terms of those holding at least upper secondary

qualifications (level 2 and 3), the UK ranked only 18 th across OECD countries.

The position for higher education is more positive with the UK placed 11 thand UK universities have an excellent reputation worldwide.

Chart 11: Highest qualification obtained as a percentage of population aged25-64

0

10

20

30

40

50

60

70

80

90

100

TertiaryUpper secondaryBelow upper secondary

OECD

average

Portugal

Turkey

Mexico

SpainIta

ly

Greece

Icelan

d

Luxembourg

Irelan

d

Belgium

Australia

UnitedKi

ngdo

m

France

NewZealand

Netherlan

ds

Denmark

Korea

Norway

Hungary

Austria

Finlan

d

Germany

Sweden

Switzerlan

d

Polan

d

Canada

SlovakR

epublic

UnitedStates

CzechR

epublic

Source: OECD

International comparisons42 also show that both public and private expenditure

on higher education in the UK is below OECD average, and that the increase

in the share of the working population with tertiary education over the last

decade has been similar to the OECD average. Up-skilling our workforce is

a major challenge we have to tackle. In doing so, we need to consider the

balance of funding between the state, the individual and private businesses/

institutions, placing funding responsibility with those who benefit most.

42 OECD (2009) Education at a glance


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The Way Forward

Science, research and innovation

Innovation is the introduction and diffusion of new products, services and

processes and one of the major sources of long-term productivity growth.

This occurs both through investment and because innovation is one of theexplanations for increases in efficiency. The provisional results from NESTAs

Innovation Index suggest that in combination these could account for two

thirds of UK productivity growth over the period 2000-200743. For developed

economies close to the technology frontier, innovative firms are an important

source of net employment creation and increased investments in innovative

processes and products are paramount for growth.

Business investment in innovation comprises investment in intangible assets

such as computer hardware and software, and advanced machinery, design,

training, market research or external R&D. Chart 12 below shows the growing

importance of nominal intangible investment in the economy. Computerised

investment has made a significant contribution to this increase.

Chart 12: Intangible Investment as a share of output

0

2

4

6

8

10

12

14

16

Intangible assets

Tangible assets

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

Percent

Source: NESTA

Although there are limitations in the relevant data, comparative analysis

suggests that UK business investment in intangible assets compares

favourably with other advanced economies.

All advanced economies use public policy to create the conditions for

successful innovation and address specific market failures that would

otherwise restrict specific forms of investment in innovation. They also

commit public funding to support their research base. Knowledge has many

43 NESTA (2009) Innovation Index Report


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public good characteristics. R&D spillovers and the risks and uncertainties

associated with research explain why private funders can be reluctant to

invest in research where there is little clear prospect of a benefit that can be

protected. A number of academic studies also show that investment in the

research base is also necessary to generate the ability to exploit knowledgegenerated by external sources or other economies44.

Higher levels of R&D are associated with higher productivity45. UK

expenditure on R&D is relatively low as a share of GDP (see chart 13). This is

mainly because of lower business R&D but this is turn can be explained by

the UKs relative specialisation in industries where formal R&D is not a major

investment as mentioned earlier.

Chart 13: Gross expenditure R&D as percentage of GDP (1999-2008)

Percent

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Canada

United Kingdom

United States

France

Italy Germany

Japan

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

Source: OECD

The UK public research base compares very favourably with other countries.

Across the range of disciplines, UK researchers in universities and research

institutes stand second only to the US in terms of volumes of high quality

(most cited) research and the UK is first in the G8 in terms of research

productivity46. This publicly accessible knowledge base produces highly

44 The most common reference sources are Cohen and Levinthal (1989) and Griffiths,

Redding and Van Reenen (2004)

45 OECD (2004) From R&D to productivity growth: do the institutional settings and the

source of funds of R&D matter?

46 Evidence Ltd (2009) International Comparative Performance of the UK Research Base

Report


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The Way Forward

trained researchers that constitute a problem-solving capability for all

sectors of the economy. Surveys also suggest that the quality of the UKs

public research base is also one of the most important factors attracting

internationally mobile business R&D to the UK.

The publicly-funded research base is part of the broader knowledge

infrastructure that enables businesses to innovate. Other important elements

include frameworks for intellectual property rights, measurement, design and

standardisation.

C. Encouraging entrepreneurialism

Central to encouraging business and individual engagement to drive growth

is ensuring there is strong entrepreneurial behaviour across the economy,

with the dynamism of the economy not held back by a business environment

which dulls entrepreneurial incentives. Sustainable growth depends on there

being incentives to drive the creation and growth of businesses.47. New and

small businesses underpin growth by stimulating innovation and making a

disproportionate contribution to job creation48.

Nearly 70 per cent of SMEs employers aim to grow their business over the

next 2 to 3 years, but only 20 per cent experience growth49. Several studies

have found that encouraging and enabling businesses to access external

advice and guidance results in business improvements that have a significant

impact on business growth and associated business outcomes such as the

propensity to export, train and innovate50.

Boosting economic growth also requires that there is a much larger group

of individuals who are actively thinking about starting a business, and have

the attributes and skills to achieve their ambitions. Evidence51 suggests that

many people in the UK, while being supportive of enterprise tend to favour

employment as a career option based on poor information which can lead

to a lack of understanding about the benefits, risks and necessary skills

associated with setting up a business.

Variations in growth and income between regions are also reflected in

differences in business start-up rates and the density of the business stock.

For example, the Northern regions have the lowest levels of entrepreneurial

47 Robinson et al (2006) Business start-up, closures and economic churn

48 Wright et al (2010) Job creation, job destruction and the role of small firms

49 BIS (2008) Analysis of Annual Small Business Survey 2007-08

50 Hart et al (2007) Economic Impact Study of Business Link Local Service, Annual Small

Business Survey 2007/08

51 GEM (2009) Global report


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activity and London and the South East the highest52. A stronger enterprise

culture, with larger numbers of people actively thinking about starting a

business and given the opportunity to develop the skills to do so, can also

help address those differences in business start-up rates between regions

and individuals.

Chart 14: Proportion of the working age population involved in startingo growing a new business

0

2

4

6

8

10

12

14

Unite

dArab

Emirates

Icelan

d

Gree

ce

Norw

ay

Unite

dStates

Switzer

land

Netherl

ands

Republic

ofK

orea

Ave

rage

Is

rael

Unite

dKing

dom

Slove

nia

Finlan

d

S

pain

Fran

ce

Germ

any

Italy

HongK

ong

Denm

ark

Belgium

Jap

an

Totalearly-stage

entrepren

eurialactivity

rate

Source: Global Entrepreneurship Monitor

According to the Global Entrepreneurship Monitor (see chart 14) the UK

outperforms several G7 countries, including Germany and France, on

measures of entrepreneurial activity and culture. But, we still trail the US and

other competitors and there are significant differences between UK regions,

indicating there is scope for improvement.

52 ONS (2008) Business Demography


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